The Fed announcement should have Trump concerned about his re-election prospects.Credit:AP

The nature of the Fed’s announcements – a majority of the members of its Open Market Committee expect no rate increases this year and the Fed plans to end the shrinking of its balance sheet by the start of October – ought to have been positive for the stock market. Instead the Dow Jones index ended more than half a percentage point down.

It was only six months ago that a signalling by the Fed of three rate rises in 2019 and a more aggressive winding down of a balance sheet still swollen by the central bank’s response to the financial crisis helped spark a dramatic plunge in stocks.

That sell-off, and the effects of the Trump administration’s trade policies on both financial markets and the US economy, has had a profound effect on the Fed, whose officials made a quite abrupt transition from hawks to doves at their January meeting. They’re even more dovish now.

Advertisement

There is a fundamental reason why what might previously have been regarded as good news by the markets (equity investors don’t like rising interest rates because they make bonds more attractive) wasn’t embraced enthusiastically by the markets.

That’s because the Fed’s expectations of where rates might be at the end of this year and, indeed, in 2020, are based on its assessment of the economic outlook for the US. It’s not bullish.

Fed officials now expect growth of only 2.1 per cent this year and 1.9 per cent in 2020, with chairman Jerome Powell saying the rate of growth had slowed more than anticipated from the strong growth experienced last year. That provides quite a contrast with the Trump administration’s forecasts of GDP growth of 3.2 per cent this year and 3.1 per cent in 2020.

Some in the markets are even more pessimistic about the outlook, with interest rate futures now signalling a probability of a rate cut this year of more than 30 per cent and a near-50 per cent chance of one early next year.

If the Fed and the markets are right, we’re not going to see the four, five or six per cent GDP growth rates that Donald Trump once said his tax cuts, increased spending, trade policies and deregulation would deliver.

Loading

The impact of the tax cuts for business and wealthy individuals is waning; the trade policies have punctured China’s growth rate, slowed growth in the global economy and damaged the profitability and competitiveness of trade-exposed US businesses; US companies used the tax cuts to buy back their shares rather than invest, and consumer confidence and spending are faltering.

With Trump saying the US tariffs on China’s exports will remain in place "for a substantial period of time" until China shows it is complying with the terms of the trade deal now being negotiated, the likelihood an early end to the damage being down to the world’s two largest economies is receding.

Trump believes the tariffs are adding "billions and billions" to US Treasury’s coffers (the analysis to date says they are actually a tax on US businesses and consumers), so is unlikely to alter the administration’s aggressive trade policies. His next target is Europe, which would add to the damage already being done to the global economy – and the US.

The other key announcement from the Fed on Wednesday, and another signal of its concerns for the direction of the US economy, related to the normalisation of its balance sheet.

In the post-crisis period, via three bouts of "quantitative easing" - the buying of Treasury bonds and mortgages by the central bank - the Fed’s balance sheet was swollen from $US900 billion ($1.26 trillion) to $US4.5 trillion ($6.3 trillion) as it printed money and injected liquidity into the US financial system.

Wall Street initially jumped on the announcement, before retreating to finish in the red. Credit:AP

In October 2017 it started to shrink the balance sheet by not reinvesting the proceeds of maturing securities. It has been reducing its holdings of bonds and mortgages at a rate of up to $US50 billion a month.

Now it says that process will end by the start of October, with the Fed halving the $US30 billion a month cap on its monthly redemptions of Treasury bonds between May and the end of September. It will also use the proceeds from maturing mortgage-backed securities to reinvest in Treasury securities.

The effect of the decisions will be to leave the Fed with a balance sheet of about $US3.5 trillion.

Loading

With the Federal funds rate set within an historically low range of 2.25 per cent to 2.5 per cent and the balance sheet massively expanded relative to pre-crisis levels, the US financial system remains awash with cheap liquidity.

Those are not settings that would reflect the super-charged growth targets Trump said he could deliver. Instead the Fed’s sudden shift in thinking and policies ought to have him worried about his re-election prospects and the rest of us worried about an even more significant global slowdown.

Stephen is one of Australia’s most respected business journalists. He was most recently co-founder and associate editor of the Business Spectator website and an associate editor and senior columnist at The Australian.